Folding Aces

Imagine you are sitting at a poker table in a Las Vegas Casino. It is a tournament that you have dreamed of playing in for years, and by some crazy stroke of luck you got in this year. All the great famous poker players from TV are here playing. You realize this is a once in a lifetime opportunity and you are just thrilled to take part.

The first hand gets dealt and you get Ace, Ace. Pocket aces, the best possible starting hand.

The action goes around the table, fold, fold, fold, ….and then, All in. Someone has just pushed all their chips into the pot.

You can’t believe your luck! Some sucker decided to push all-in on the first hand and you are loaded with Aces! The next three players quickly fold, and the action gets to you. You’re ready to put all your chips in and call – but then, you hesitate.

You’re odds of winning with pocket Aces against one other player is somewhere between 70 and 80% – dominating odds. The right move is to call and its not close.

But, this is the first hand. If you lose here your dream comes to an end. It’s a very high probability of winning, but its not a certainty. 80% means you would lose that hand 1 time out of 5. What do you do?

Most people here make the ‘right’ decision and call; and very likely, they would double their chip stack and be in a better position for the rest of the day. But you are also taking a 20 – 30% chance of being the first one eliminated. Everyone would understand – “I had Aces, I had to call.” But just because its excusable does not make it easy to spend the day watching from the sidelines. ‘Bad beats’ happen all the time – and not just in poker.

A few months ago I posted the following tweet about my investment process.

My investment process usually starts and stops with 2 questions.

What is my probability of being right?
What is the consequence of being wrong?

It got a lot more reaction than I expected, including some great questions so I thought it worthwhile to expand a bit on this premise.

Too often the investment world thinks in black and white. Right and wrong. You either did the work, read the research, crushed the Excel models, and came to the right assessment, or you screwed up. It’s what Annie Duke, who recently made the podcast rounds to promote her book Thinking in Bets, calls ‘resulting’. ‘Resulting’ is where the outcome determines whether you made the right move. Did the trade make money? Then you were right and did a good job. If it lost money, you did a lousy job.

What is the probability of being right?

Some investors can move beyond the world of right or wrong. They understand that a lot can happen and you cannot know anything for certain. This is why my favorite definition of risk is the one quoted by Howard Marks in his great book The Most Important Thing.

“Risk means more things can happen than will happen.” – Elroy Dimson

Single minded people believe that things are bound to happen – that you could figure it out if you were just smart enough or had enough information. Investors thinking probabilistically understand that nothing is certain. There are only degrees of likelihood.

“Probability is not a mere computation of odds on the dice or more complicated variants; it is the acceptance of the lack of certainty in our knowledge and the development of methods for dealing with our ignorance.”

The future is unknowable, and thinking otherwise is folly. When people become certain that something will happen that is when they get into the most trouble. Indeed it is one of the most consistent market inefficiencies in history – People will treat as certain something that has a very high probability of happening, and treat as impossible something that has a very low probability of happening.

What is the consequence of being wrong?

I’ve had this post (A Long Chat with Peter Bernstein) by Jason Zweig saved because I think it is so fundamental on how people should be approaching the investment process. The late Peter Bernstein is one of my favorite financial writers (Against the Gods is a must read) and Jason Zweig is one of today’s foremost investment commentators. You should really read the entire thing (and read again if you already have) but for our purposes, Peter Bernstein goes through the biggest errors investors make. The first one is ‘extrapolation’ (which is a topic that deserves it’s own discussion … another time perhaps), but the second one is Thinking of probabilities without regard for the potential consequence.

Peter Bernstein on the most famous investor mistakes

To quote Mr. Bernstein:

Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.

Even if you have a very strong probability of being right, if the consequence for being wrong is unbearable, you should not take the risk.

Imagine you face a wager with 90% odds of paying you $1 million with a 10% chance you have to pay $750,000. That is an easy bet to take if you have the money. But what if your net worth is only $200,000 and you have three kids that play travel soccer and are enrolled in private school? You would face a 10% chance of losing your entire retirement savings, your house, any personal property of any value. The statistician would say there is no question you should take this wager. The estimated value is positive $875,000 (90% x $1m plus 10% x -750,000). C’mon! Take the bet! It is the mathematically appropriate thing to do!

But can you afford to lose? If the answer is no, walk away, avoid the possibility of ruin. That is appropriate risk management.

Are you thinking about folding those aces yet?

Today’s lessons

Tesla, that polarizing electric car company ;-), has been in the news a lot lately. The stock has a very large, and very loud, group of short sellers (betting that the stock will go down). The rationale is logically sound – the company cannot hit production targets, there is a huge amount of turnover among executives, they are burning cash at an alarming rate, not to mention the craziness of CEO Elon Musk.

However the risk of being in a short position was on full display in recent weeks. Even if all the arguments of the short sellers are ultimately true, there are still things that can happen which make a short trade disastrous. The following tweet was a case in point.

While this is tweet is now under investigation by the SEC (ultimately strengthening the short case), were he able to take the company private at $420, all the short positions would have locked in a loss. It is a case of being right in theory but wrong on the outcome.

Even still, the stock has dropped down to around $300, and the short sellers believe it has much farther to go. But the cult following around this company and their enigmatic leader, mean that there is a meaningful chance that even with the difficulties the company faces, it could still continue to rise – defying logic or financial common sense. It could simply rise on the faith and enthusiasm of its sycophantic followers.

Stocks that do not trade according to fundamental valuations are particularly dangerous. When the consequence of being wrong is unknown and potentially huge it is a dangerous risk to take.

Back to the Poker Game

First hand of your dream tournament. The bet is to you for all your chips and you have the best possible hand. You know your probability to win is very high, but your consequence of being wrong is to go home before you even get a chance to order a drink.

The poker players out there would say call. It’s the right move and poker is a game of exploiting statistical advantages.

Me? Perhaps this reinforces why I would never be playing in a high stakes dream tournament, but I would probably fold them – face up just to let everyone know I was nuts. The pain of hitting a bad beat and going home would be far worse than the benefit of doubling my chip stack.

But then again…. it would be a good story to tell.

Until next time……

“The word ‘risk’ derives from the early Italian risicare, which means ‘to dare’. In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about.” – Peter L. Bernstein

Bookshelf

The Kraken

Below the thunders of the upper deep;
Far far beneath in the abysmal sea,
His ancient, dreamless, uninvaded sleep
The Kraken sleepeth: faintest sunlights flee
About his shadowy sides; above him swell
Huge sponges of millennial growth and height;
And far away into the sickly light,
From many a wondrous grot and secret cell
Unnumber'd and enormous polypi
Winnow with giant arms the slumbering green.
There hath he lain for ages, and will lie
Battening upon huge seaworms in his sleep,
Until the latter fire shall heat the deep;
Then once by man and angels to be seen,
In roaring he shall rise and on the surface die.